* British, German small-cap indexes hit record highs

* M&A, valuations and economic recovery to fuel rally

* Analysts see scope for shares to rise nearly 40 percent

By Atul Prakash

LONDON, Nov 1 (Reuters) - Europe's small companies are emerging as the stars of the third quarter earnings season, prompting analysts to raise forecasts for future profits and investors to bet on new highs in share prices.

The small-caps' greater exposure to recovering domestic economies, compared with the more globally focused blue chips, is filtering through into bigger positive earnings surprises and analyst upgrades, encouraging investor interest in stocks that were considered too risky during the financial crisis.

Small European companies have so far reported about 8 percent higher earnings than analysts expected, while larger companies have lagged forecasts by 1.5 percent, according to StarMine data.

Thomson Reuters I/B/E/S estimates show European small cap earnings rising nearly 27 percent in the next 12 months against 9.5 percent for large caps.

"More and more investors are now looking for additional value in a low growth environment and that's why so many people are interested in small caps," Stefan Scheurer, senior analyst at Allianz Global Investors, said.

"Their valuations, on a price-to-book ratio, are attractive, performance has been good and dividend yields in most cases are higher than government bond yields."

Among small caps, energy and industrial sectors have been the best performers on the earnings front, with 86 percent and 62 percent of companies respectively beating or meeting third-quarter earnings forecasts.

Havila Shipping, business process outsourcing company Transcom Worldwide, Siem Offshore , lighting systems company Fagerhult AB, German homeware firm Villeroy & Boch, and Belgian maritime group CMB are among the small companies who had strong third quarter numbers, beating expectations.

Boosted by expectations of economic recovery and increased appetite for risk, the STOXX Europe 600 small cap index is up 19 percent, near recent six-year highs, against a 13 percent gain for the FTSEurofirst 300 this year. On a country level, small-cap indexes in Britain and Germany have set record highs, outpacing gains in blue chips.

But, despite the price gains, the small caps still look cheap relative to history, which analysts say leaves room for them to outperform further.

Shares in small and mid-cap firms could rise nearly 40 percent before they hit their historical peak in terms of price-to-book ratio, while their dividend yields offer the scope for more than 30 percent gains, according to JPMorgan.